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TIPS finally are showing why they should be part of your insurance against heightened inflation.

TIPS, of course, are Treasury Inflation-Protected Securities. They are Treasury bonds whose principal is guaranteed to grow with inflation. Their coupon reflects the interest that the bonds pay on the adjusted principal amount.

How to manage inflation

If inflation picks up, it can have an impact on a range of investments.

Currently, for example, TIPS with a 10-year maturity now yield 0.74%, which means that if you hold until maturity you will make 0.74% above and beyond whatever the inflation rate is over the next decade. Or, to put it another way, your real (inflation-adjusted) return between now and 2028 is a guaranteed 0.74% per year.

To see why TIPS are good insurance against higher inflation, consider the yield on regular, non-inflation-adjusted, Treasuries. The 10-year Treasury currently yields 2.86% versus an expected 10-year inflation rate of 2.12% (per the St. Louis Federal Reserve). If that expected rate turns out to be what inflation actually is, then the regular Treasury's inflation-adjusted yield will be 0.74% annualized — almost the same as the 0.74% yield on the TIPS.

Notice, however, what will happen if the CPI rises at a higher rate between now and 2028. Because that 2.86% yield on the regular 10 year is fixed, its margin above the CPI will shrink. It could even turn negative, if inflation averages more than 2.86% over the next decade. The 10-year TIPS, in contrast, will continue to provide a constant 0.74% margin above the CPI.

None of this information is new, of course, since we have all known about TIPS for years. But what is new is that we finally have an opportunity to see if TIPS can live up to their advance billing.

They passed with flying colors. Consider their performance since February 11, 2016, the date two years ago when the 10-year expected inflation rate hit its recent-year low. The expected inflation rate then was 1.18%, compared to 2.12% today.

A turning point for bond yields

It may be a sign that investors finally believe in the post-crisis recovery.

In other words, despite a near doubling of inflation over the last 24 months, and a corresponding increase in the 10-year yield of more than a percentage point, the TIPS all produced impressive returns. Regular Treasuries, in contrast, unsurprisingly produced sizeable losses.

Furthermore, there is no reason not to expect TIPS to continue to perform well if future inflation turns out to be even higher than is currently expected.

How therefore should you divide your fixed income allocation between regular Treasuries and TIPS? The answer depends on much of a gambler you are. If you believe interest rates will decline from here, for example, then investing in regular Treasuries would be the logical choice. That's because they will rise in value as rates fall.

But if you're not a gambler, then a healthy allocation to TIPS is compelling. The worst that could happen is for inflation to be lower than expected, which would be good news for the other parts of your portfolio even if it puts a damper on the performance of the TIPS themselves.

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